Behavioral Finance Case Study

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Behavioral Finance and Client Education Classic finance theory assumes that people are rational, however a person does not have to look very far into that assumption to realize that is not always the case. A study conducted by Brad M. Barber and Terrance Odean highlights this anomaly. They found that from 1991 to 1996 the market returned an annual 17.9% verses the average household net return of 16.4%. The households that traded the most earned an annual return of only 11.4%. This strikingly debunks the theory that investors are rational. Investors act with emotion and overconfidence, not rationality as has been assumed in past theory (Barber and Odean). Across the country, financial planners and wealth managers are asking what behavioral finance looks like, what can they do with it. Most advisors have experienced the frustration of developing a sound plan for their clients, only to have their client make excuses or end up ignoring the plan. This paper will highlight the history of behavioral finance, describe biases commonly employed by financial planning clients, and give suggestions as to ways financial advisors and wealth managers can work with clients with these biases and use positive versions of the biases to help with client education and understanding. A History Daniel Kahneman made great leaps in the field of behavioral economics and by extension behavioral finance. He pointed out that people heavily are influenced by emotion and their intuition. He introduced the idea of a person having “two minds”: an intuitive mind and a reflective mind. The intuitive mind forms quick judgments and are the things that simply come to mind. The reflective mind is the slow thinking, analytical part. Most decisions people make are made b... ... middle of paper ... investor types based on research done by Michael Pompian. Barrett Ayers, the firm’s CSO and managing director states that the topics of focus include “risk tolerance, confidence level, and tendency toward emotional or cognitive investing” (Skinner). This approach allows advisors to communicate more effectively with their clients based on client needs. Conclusion Investors are not by nature rational investors, as was assumed in economic theory. Investors are subject to many behavioral biases and heuristics such as framing, representativeness, and loss aversion. By embracing the fact that your clients are behavioral and will react with emotion and behavioral biases, you will open yourself and your business to a new realm of possibilities. In the future advisors should work with clients to identity behavioral biases and identify the best solutions for an investor.
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